Stumped on Plan Loan/Payroll Repayment Default Issue

[ERISAatty]

I have found other strings on here that discuss plan loan defaults, but none with just these facts, and none post PPA '06.

So here goes, for any one who might have opinions/insight:

-A 401(k) Plan provides that plan loans "will be repaid by payroll deduction."

-Minnesota employee now wants to revoke authorization for payroll deduction (based in my research, employee must consent under state law to deduction, and has right to revoke authorization).

-Employee has been told that taxes/penalties are involved if loan because a 'deemed distribution' and does not care; still wants to cease payroll deductions (and has no other plans to repay loan).

-Employer does not want to permit cessation of loan repayment by payroll deduction.

Questions are:

-Is state law the final answer here?

-I know that PPA amended ERISA to preempt state wage laws with respect to contributions to plans for automatic contributions - is there any chance that preemption could also apply here?

- I spoke on the phone with an EBSA representative, and he didn't seem to have a concern that this kind of default, in an individual account setting, raises an 'adequate security' problem such as to jeopardize the plan loan prohibited transaction exemption.

- The 1.72(p)-1 regs (see, e.g. Q&A 19(b)(3) anticipate that revocation of a payroll deduction authorization would result in a deemed distribution, although the example there is limited to subsequent [or second, post-default] loans, for which payroll deduction is mandatory). Since, per the plan terms, payroll deductions are mandatory here, too, I think this applies and anticipates that the employee has the right to revoke. Of course, these regs pre-date PPA '06, so I'm still not clear on if there's any chance of a preemption argument now.

-What about not following the plan terms if the repayment stops. I guess at that point, loan is recharacterized as distribution, so plan terms aren't technically violated?

Any thoughts on a clear answer about whether employer has to honor the request to stop the payroll deduction for repayment?

[rcline46]

I am not an attorney, nor am I familiar with MN law, but here goes:

The employee has the right to revoke deductions, and if not paying on the loan will have a deemed distribution with tax consequences. The employee will still owe the loan which might prevent any future loans. (I think a default would also cause the trustee to deny any future loans anyway.)

My concern is if the loan is 'fresh' (new) then it may have been taken under false pretenses (no intention of repaying the loan) which is fraud under the loan regs. I doubt the plan administrator would wish to pursue this line, but the IRS or DOL, under audit, might.

[Guest Bret]

You might argue that state laws on withholding limitations are preempted under regular ERISA preemption. ERISA requires the plan to be administered according to its terms and its terms require withholding. I don't know if there is case law on this issue or not, but it seems like a good faith argument. I think the problem is that ERISA does not require payroll withholding. That payroll withholding is "additional security" under the loan regs is a pretty good indication that is not required for "adequate security" under ERISA 408.

Regardless, the plan administrator is in a tough spot -- follow state law or the plan provision. There is no clear answer and the IRS has acknowledged this informally.

We've settled on a risk analysis. I think it is much more likely that an employee will contact his state labor department and complain that his employer won't stop withholding than it is that the IRS or DOL will audit the plan and discover that payroll withholding on a plan loan has stopped. Further, even if the IRS or DOL discovers the issue, it will be difficult for them to impose any non-nominal fine when the employer was complying with a state law that does not conflict with ERISA directly. The IRS recognizes an ambiguity in the law that the state department of labor is less likely to understand.

We generally advise administrators to send a letter explaining the effects of ending withholding, that withholding will end only upon the participant's subsequent written request, and that withholding may be started up again to continue repayment before default. After payments end, default and deemed distribution will occur as otherwise provided under the plan's loan procedures.

Another solution on a go forward basis is to allow withholding to stop if required by state law in the plan doc and all loan documents. The problem with this is that TPAs like to require withholding and generally include a withholding requirement in loan procedures and promissory notes.

[Guest Sieve]

I think it would be a big stretch to try to apply the pre-emption provisions of the auto enrollment regs to a plan loan. I think you just have a default when the payroll election is revoked by the participant--there's really nothing that the administrator can do to prevent the revocation, and I can't see the IRS or DOL objecting.

But, commercially comparable loan practices might require the fiduciary to deny a loan to this individual in the future as a result of the action taken the first time around.

[Bird]

IMO, the plan provision that says loans will be made by payroll deduction means "as a convenience to the Employer, any loan payments made will be done through payroll deduction [and if a participant stops the payroll deductions so be it]" not "loan payments will be made through payroll deduction and the participant has no control over those deductions and must continue them forever and ever."

Not such a big deal to stop, I think, although I'd have at least mild concerns about doing this immediately after loan inception.

[Jim Chad]

I want to pay devil's advocate here for a minute.

Bird, I think you are right about it being for the convenience of the employer. But more important, it was in the contract to get the loan. What gives the Participant the right to change the terms of the loan after he has the money? Can he also change the interest rate?

Bret, I think your risk analysis makes a lot of sense. What I wrote above is where I am after 5 minutes. If I thought about this for an hour, I think I would agree with all of you.

[Bird]

Bird, I think you are right about it being for the convenience of the employer. But more important, it was in the contract to get the loan. What gives the Participant the right to change the terms of the loan after he has the money? Can he also change the interest rate?

Same response - as I see it, the participant is agreeing to make any loan payments by payroll deduction, not agreeing to an irrevocable stream of payroll deductions. I agree with Bret's "risk analysis" - well put.

[R. Butler]

http://benefitslink.com/boards/index.php?s...c=10321&hl=

I think that ERISA does pre-empt state law. I discussed this in a prior thread on the same subject hoping for an explanation to convince me that I was wrong. Not convinced, but I still acquiesse to the majority that you stop the withholding. Seems like a safer approach more than anything.

[Peter Gulia]

The originating question also offers a glimpse into one of many reasons why it sometimes matters to consider exactly which person is the plan's administrator.

If an employer is not the plan's administrator and in no other way is a plan fiduciary, ERISA might not always impose on the employer (rather than the plan's administrator) a duty to follow the plan. And it is unclear what contract obligation an employer might have to follow the plan. Moreover, even if it's clear that an employer breached a plan contract obligation, it's not obvious what remedy should be had by the participant who requested the act that is the breach.

Alternatively, an employer that is also the plan's administrator and prefers to refuse the participant's request to stop the wage-deduction payments ought to have good grounds if the State wage-payment law is preempted. Further, as long as the plan's administrator has taken its position loyally and prudently (after getting its lawyer's advice), the expenses of defending the employer and plan administrator against a State labor regulator's proceeding ought to be a proper plan administration expense.